The Future Of Portable Alpha

June 22, 2009

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Portable alpha approaches—which essentially involve seeking beta from one asset class and alpha from another—have fallen under a cloud, as have many other investment strategies, in the wake of the recent market turmoil. However, they can yield potentially powerful results for investors both in terms of risk-adjusted excess return and diversification benefits, which explains, at least in part, the heightened interest in portable alpha following the equity market sell-off in 2000–2002. Traditional stock and bond investment return expectations were relatively low, and investors were concerned about meeting return targets that were in many cases in the 7–10 percent range. As a result, investors as a group were more open to new investment categories and approaches, including those that employ the use of derivatives and leverage, like portable alpha.

At the time, portable alpha and related concepts were touted as a new paradigm in investment management, and even the holy grail of investing. The variety of different approaches to porting alpha and the number of providers of related products ballooned, as did the conferences dedicated to the topic. Generally speaking, investors seemed happy with the results. Of course, most of the newer approaches to portable alpha were implemented in the low- and declining-volatility environment that ended in 2007, with risk premiums initially rising to levels closer to historical averages before spiking to new highs this past fall.

Unfortunately for some investors, successful portable alpha implementation has proven to be much more complicated in practice than it may sound in theory. Portable-alpha-related losses experienced by some have been highlighted in the public domain, likely causing some investors to question the merit of the entire concept.

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What does the future hold for portable alpha? The fundamental concepts that provide the basis for the viability and benefits of portable alpha for long-term investors are very much alive and well. There have been important lessons learned, though. As a result, we are likely to see a bifurcation of the marketplace where portable alpha approaches that share certain important characteristics are likely to survive and even thrive, while others may disappear. In particular, we believe approaches that capitalize on the attractive risk premiums available in the high-quality, relatively liquid fixed-income arena merit serious consideration by investors.

Portable Alpha, Defined

Not surprisingly given the wide variety of approaches employed, the definitions of the term “portable alpha” vary depending on who you ask. So far as we are aware, though, all strategies that fall under the portable alpha umbrella involve the use of derivatives (or a similar borrowing arrangement) to obtain the desired asset class or market index exposure, typically referred to as “beta,” thereby allowing risk-adjusted excess returns or “alpha” to be sourced from an entirely distinct asset class or active management strategy. Central to the idea and also the potential value of portable alpha are the concepts of borrowing to achieve higher returns, and diversification as a means to increase the return per unit of risk. Sound familiar? These are also two of the key concepts that underlie modern portfolio theory as introduced in the middle of the 20th century and detailed in every investment textbook.

The potential diversification benefit is derived from the fact that an investor’s capital may be invested in assets that are independent from—and complementary to—the derivatives-based beta exposure. Let’s say that an investor has $1. They can buy $1 of the desired index exposure for just a few pennies using derivatives, and have the rest of the $1 to place in an entirely separate and distinct investment. Simplistically speaking, the combined return will be equal to the total return of the index (beta) minus the associated financing rate (as explained below) plus the total return of the collateral or alpha strategy. The returns from the two components are additive, while the risk is not entirely additive—as it would be if the two were perfectly correlated.

It is difficult to predict future correlations: Assets that historically have not been correlated or have had relatively low correlations during periods of low volatility may turn out to have very high correlations during periods of market stress. Nonetheless, so long as the risk factor exposure in the alpha strategy is transparent, investors should be able to determine whether or not a material, positive diversification benefit should exist over the long term. One example of this may be the combination of equity derivatives and a carefully risk-controlled, high-quality, fixed-income alpha strategy portfolio. Of note is the fact that the Barclays Capital U.S. Aggregate Bond Index had a positive return of 5.2 percent in 2008. Historically, this index has had a negative correlation with equities during periods of equity market stress, which logically makes sense due to the flight-to-quality impact.

The borrowing component of portable alpha approaches is typically accomplished using index futures or swaps that are designed to provide the total return of the associated market index, less a financing rate, as noted above. The financing rate associated with index ownership using derivatives is consistent with other “buy now, pay later” forms of asset ownership—financing an appliance, a car or a house, for example. The important question from the standpoint of prospective investors in a portable alpha strategy is: Are there readily available, liquid, cost-effective derivatives available to replicate my desired index or beta exposure? In the case of certain indexes or market exposures, the financing cost may be compelling for long-term investors, while in others, the cost may be significantly higher if the exposure is even available synthetically.

 

 

The Evolution Of Portable Alpha

The vast majority of portable alpha approaches seek to outperform the equity market, and thus employ equity index futures or swaps to replicate the returns of the equity market on an ongoing basis. This is not surprising, as it was the introduction of S&P 500 index futures by the Chicago Mercantile Exchange in 1982 that paved the way for broad market “portable alpha” index enhancement. Specifically, the advent of the S&P 500 futures contract presented investors with the opportunity to maintain exposure to the equity market over the longer term at a short-term money market rate cost. For equity futures contracts, this cost is embedded in the price of the futures contracts and is usually very close to 3-month LIBOR, at least for highly liquid futures contracts. In the event that it drifts higher for some reason, arbitrageurs will typically step in, thereby pushing the financing rate back toward LIBOR. In the case of total return index swaps, the financing cost is specified as part of the contract, and also most commonly linked to short-term LIBOR rates.

The key to achieving higher returns than the reference beta or index lies in the performance of the alpha strategy relative to the money market cost of financing. It follows that portable alpha strategies may benefit from a “time horizon arbitrage” of sorts that is unique relative to most traditional actively managed strategies, due to the mismatch between the short-term money market cost of the beta exposure and the longer-term horizon of the investor. Rather than investing the capital retained solely in money market investments, investors can capitalize on their longer time horizon by investing in assets that bear some amount of additional risk in exchange for a higher expected return. This was the idea when Pimco launched its StocksPlus strategy shortly after the introduction of S&P 500 futures contracts more than two decades ago: Capitalize on long-term equity investor horizons by owning equity futures contracts collateralized by a portfolio of liquid, high-quality, short-term fixed-income assets that provide a modestly higher incremental yield and expected return above money market rates.

Over the years, investors have gravitated to portable alpha for multiple reasons. There is a certain appeal to the concept in that it reconciles the need for higher returns while still offering many of the same advantages of passive investing. It is commonly agreed that passive investing offers many significant advantages for investors across assets classes, including low costs, liquidity, capacity, diversification and ease of use. Portable alpha can offer many (in some cases, all) of these same benefits. It also is particularly compelling in segments of the market where it is difficult to identify traditional managers that produce consistently positive excess returns, such as the U.S. large-cap equity space. Portable alpha strategies avoid the risk of individual security selection by “owning the market” through derivatives, but expand the universe of strategies that can be employed to generate alpha relative to a given benchmark. In addition, there may be important improvements in the overall risk profile if there is a low and relatively stable correlation between the alpha strategy and the desired market (“beta”) exposure, as noted above, and also to the extent that the overall strategy provides excess returns that are uncorrelated with other actively managed strategies owned within an asset class.

Given all the potential benefits to investors and the increased interest on the part of investors, it is not surprising that a large number of variations of the portable alpha concept have been introduced by investment managers or undertaken by investors directly, as discussed toward the beginning of this article. A related reason for all of the interest and flows into portable alpha strategies is the substantial growth in the index derivative markets. Relative to even as recently as five years ago, the number of available futures contracts is much broader, now including international and emerging markets equity contracts as examples. At the same time, the over-the-counter (swap) markets became substantially more liquid and active. Movement toward standardized over-the-counter contractual arrangements has also improved the willingness of investors to establish such exposures.

It’s important to remember, however, that no strategy is without risks and pitfalls. Over the past few years, we’ve seen that portable alpha is not immune to the return-hungry, risk-agnostic attitude that permeated some parts of the marketplace. The downside of excessive leverage and poor risk evaluation and measurement ultimately contributed to the broad-based market dislocations and de-leveraging we’ve seen recently. Various portable alpha strategies were marketed without any mention of the downside risk of the alpha component—the beta component was assumed to have risk, while alpha strategies that promised returns of 4 percent over LIBOR or more (after accounting for very high fees) in some cases were essentially put forth as being risk-less to the end investor, such that investors may have been led to believe that their downside was limited to that of the beta component alone. In addition, often there was very little mention or consideration of the liquidity that is absolutely critical to the ability to maintain the derivatives market exposure during volatile and downward-trending market environments, among other key aspects of portable alpha that may have been glossed over. From our perspective, this was quite concerning—and rightly so, as it turns out—which is why we actually felt compelled to write the book “Portable Alpha Theory and Practice: What Investors Really Need to Know,” turning in our first draft to the publisher well before August 2007. Our colleague Chris Dialynas put it best in the epilogue:

“Ironically, what began in the early 1980’s as a simple finance arbitrage Pimco portable alpha strategy has evolved in some cases to highly leveraged, unregulated portable alpha hedge fund strategies. Both are referred to as the alpha source in a portable alpha context, but they are vastly different in terms of the potential downside risk.”

 

 

Alpha And Beta: It’s the Combination That Matters, As Does The Execution

This is not to say that all portable alpha strategies that involve the use of hedge funds as the alpha strategy are bad or highly risky. There are surely any number of successful, prudent approaches that involve hedge funds. Regardless of the approach, though, as a starting point, proper quantification of investment and operational risk in portable alpha programs is a necessary ingredient to well-informed investment, benchmarking, risk budgeting and asset allocation efforts. Risk management and measurement is a crucial component of a successful portable alpha strategy.

While portable alpha may seem to be an elegant and low-risk way to earn excess returns in addition to the return from the reference market index, there really is no such thing as a free lunch in the financial markets. The fundamental laws of investing apply to portable alpha just as they do to any other type of investment. It is almost always necessary to take some type of risk in order to generate return over money market rates. While portable alpha strategies may seem simple in theory, they cannot outperform the reference index 100 percent of the time. The primary risks of portable alpha strategies in this regard can include: (1) the potential for under-performance in the collateral (alpha) portfolio, (2) a spike in the financing costs for futures/swaps, (3) margin calls on the derivatives in a falling market, which force the liquidation of the most liquid (and highest-quality) parts of the portfolio, or (4) operational errors.

Investors should carefully evaluate both the risk of the derivatives-based index exposure and the alpha strategy when attempting to understand the overall risk of the strategy. Focusing first on the alpha side of the equation, investors should understand the liquidity of the portfolio. Futures margin is typically settled on a next-day basis, and swap collateral requirements may be settled as frequently as daily in stressed market environments. Consequently, understanding portfolio liquidity is critically important. Similarly, understanding the alpha portfolio’s expected behavior during periods of market stress may provide insight into how the portfolio as a whole behaves in down markets. Well-informed analysis will focus on the sources of return in the alpha portfolio and the risk factor exposures that drive those returns. Further analysis should focus on the likely correlation of those risk factors across different market environments and to what extent the risks are identifiable, measurable and can be diversified.

 

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For instance, combining a derivatives-based fixed-income index exposure with a hedge fund alpha strategy may result in a strategy with a very different risk profile than the passive fixed-income index. This can be problematic because the passive fixed-income index presumably serves as the benchmark for the overall strategy and also serves as the proxy for the strategy in the investor’s asset allocation. An illustrative example is shown in Figure 3.

The analysis in Figure 3 compares a hypothetical investment in a portable alpha strategy where the collateral portfolio is invested in the HFRI Fund-Weighted Composite Index (the HFRI composite index provides an equal-weighted average return of over 2,000 hedge funds). The derivatives-based beta or index returns are approximated by the return of the Barclays Aggregate Bond Index minus 3-month LIBOR.

How satisfied would an investor have been with this investment in 2008? Based on a cursory review of the data in Figure 3, it is challenging to have much to say on the positive front in light of:

• A negative excess return of 22.4 percent and negative absolute return of 17.2 percent (the bond index returned a positive 5.2 percent)
• Over two times the volatility of the passive bond index

But had you been invested in the strategy for the last 10 years, how satisfied would you be? Even with 2008’s challenges, the strategy referenced in this example produced a very healthy excess return of 3.6 percent (excluding any overlay costs, other costs and fees and “slippage” related to imperfect alignment between the value of the underlying hedge fund investment and the bond overlay). Very nice to have the extra returns for sure, but is this really a bond investment? Look closely at the risk statistics. The strategy exhibited more than double the volatility of bonds and was more correlated (61 percent) with the S&P 500 than with the Barclays Aggregate (46 percent). So not only might it be debatable as to how to classify this investment, it may be challenging to properly benchmark the strategy. Based on the historical performance characteristics of the strategy, can one really assume that it will behave in a similar manner as the passive bond index? Return and especially risk assumptions should be ratcheted up for any plan-level risk budgeting and asset allocation efforts.

 

 

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These same challenges are likely to present themselves when the derivatives-based beta exposure is an equity index. In addition, the actual and potential volatility and downside risk of the equity market is very relevant when considering the appropriate level of liquidity in the collateral alpha strategy—as many who executed portable alpha strategies during the relatively benign low-volatility and positive equity market return period from 2003 to mid-2007 can certainly now attest.

In Figure 4, note the differences between the passive S&P 500 Index performance in 2008, and over the last 10 years, relative to a hypothetical portable alpha strategy. As before, the hypothetical returns assume that the collateral portfolio is invested in the HFRI Fund-Weighted Composite Index and the passive index derivative return is approximated by the return of the S&P 500 minus 3-month LIBOR. Over the 10-year period, the strategy generated very attractive excess return. However, most striking from a risk standpoint is that this combination results in an equity beta coefficient that is nearly 40 percent higher than the index.

 

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Is this still an equity strategy with a risk profile that is similar to the S&P 500? The answer to that question for most is probably a resounding “no.” As an interesting point of comparison, the 10-year historical beta of this strategy is higher than that of any traditional active equity manager universe over this time period.1

We offer these examples not to disparage the concept of using hedge fund strategies as the collateral alpha strategy investment, but rather to illustrate how different portable alpha approaches can have risk-and-return profiles that differ, perhaps meaningfully, from the referenced passive market index. Successful portable alpha implementation over the long term is contingent on appropriate risk management and measurement—which, in turn, requires an appropriate level of transparency. Again, we believe an understanding of the potentially higher downside risk of such a strategy is important at the individual investment, asset class and overall plan levels.

 

 

Derivatives-Based Beta Management Should Not Be Free!

Although often overlooked in marketing presentations that are focused on the alpha side of the equation, derivatives-based beta management is not nearly as easy or straightforward as many believe. Derivative instruments are the principal building block for portable alpha strategies because they allow investors to finance the desired market exposure at what is typically a short-term money market rate. However, complexities exist in liquid markets, such as S&P 500 futures, and even more so for market exposures that are more complicated to replicate, like multisector fixed-income indexes. The investment and operational complexities of establishing and maintaining such exposures may involve significant costs and result in additional tracking error and/or counterparty risk.

While a discussion of all of the evolving operational nuances and requirements associated with the use of derivatives is beyond the scope of this article, in short, the use of futures requires Commodity Futures Trading Commission (CFTC) and other regulatory considerations, daily margin flow management and usually a quarterly roll of exposure. The use of swaps introduces legal and contractual considerations. Other issues to take into account with swaps include counterparty risk and associated cash flow parameters and the required typical annual roll of exposure.

The last several months have presented significant tests for many of the “behind the scenes” efforts related to derivatives management. Liquidity management was subjected to an extraordinary stress test at the hands of the severe and sustained market declines. At the same time, counterparty risk evaluation became increasingly important in an environment of uncertainty for many Wall Street broker-dealers. Disentangling the payables and receivables associated with derivatives contracts at Lehman Brothers has been an unpleasant task for many asset managers and their clients.

In circumstances where there were sharp moves in the net assets of the underlying alpha portfolio, this necessitated more routine adjustment in the notional value of derivatives to align the value of the overlay with the underlying assets. The level of volatility underscored the challenges of attempts to separately manage the alpha and beta components (as opposed to implementation within a single integrated portfolio). In such “unbundled” approaches, the investor typically may bear the responsibility for all of the risk monitoring, reporting selection and oversight of separate alpha strategy manager(s) and overlay manager(s). However, the rebalancing may not have been the worst of it for these investors. One can imagine the liquidity challenges that may have been faced by investors who collateralized equity derivatives with hedge fund exposure in the event that the rapidly declining equity market exhausted their initial liquidity reserves at the same time their underlying hedge fund strategies suspended redemptions.

Nonetheless, although most portable alpha approaches probably under-performed in September–November of 2008 (it is hard to imagine otherwise when virtually all assets under-performed LIBOR), possibly resulting in under-performance for the entire calendar year, the long-term value potential of many different types of approaches, and the concept as a whole, is still very real—and perhaps even stronger than ever in some cases. That said, portable alpha is not necessarily universally applicable and as straightforward as the example referencing the S&P 500 futures implies, as liquid, cost-efficient derivatives do not exist for all commonly referenced market indexes. The broad bond market is perhaps the best example.

Bond Market Beta Replication: It’s Complicated

While a wide variety of liquid equity index derivatives are available for use in portable alpha programs, there are fewer liquid and/or low-cost options available for bond market indexes. Historically, the total return swap market has not offered reliable, low-cost replication of broad, multisector bond indexes either. Similarly, at the time of this writing, there is not a liquid futures contract on a broad multisector index. So, for investors wishing to be long, for instance, the Barclays Capital Aggregate Index via total return swaps, there are very meaningful challenges in attempting to obtain that index return precisely. The primary challenge is that broad market bond indexes such as the Barclays Aggregate contain an enormous quantity of bonds (the Barclays Aggregate includes approximately 9,000 bonds).

Recognizing the challenges in exact replication of bond indexes using derivatives, a number of innovative approaches have been developed to facilitate synthetic (approximate) replication of broad bond indexes using forward-settling liquid instruments and liquid derivatives. While a thorough discussion of the merits of such strategies is beyond the scope of this article, worthy objectives are to provide meaningful cost savings relative to expensive total return swap index replication, not be reliant on any one counterparty for the derivatives-based exposure, and to potentially deliver modest performance improvements at the same time.

Fixed-income derivatives are oftentimes more liquid than the underlying bonds, and in many cases offer opportunities to generate a higher return. The good news for investors seeking to replicate fixed-income indexes synthetically (with minimal-to-moderate cash outlays) is that it is possible to utilize a derivatives-based replication portfolio designed to closely track the return of a broad fixed-income index. For managers such as Pimco, this may be a natural extension of efforts in core-plus-bond accounts.

 

 

Bonds As A Source Of Alpha

Retaining a focus on the fixed-income market, but looking to the excess return or alpha side of the equation, high-quality fixed-income strategies may be an excellent alpha source when paired with higher-risk market exposures (i.e., equities, commodities, etc.). The generally low correlation of high-quality fixed-income assets to higher-risk assets may result in risk-reducing diversification. Higher-quality, diversified fixed-income strategies may also impart important capital preservation and liquidity characteristics along with structural return advantages. Finally, compliments of the painful de-leveraging and extreme market dislocation, high-quality fixed-income yields outside of the Treasury sector are currently at extraordinary levels by most measures—relative to history, relative to LIBOR and relative to the apparent downside risk.

As was seen in 2008 and based on other periods of equity market decline, high-quality segments of the bond market have tended to perform relatively well. Looking across asset classes and across investment strategies during periods of financial market stress—for example, when the equity market is experiencing a material price decline—many investments exhibit a high correlation with equities. The exception is often high-quality segments of the bond market, which typically benefit from a flight to quality during such periods. The end result may be capital preservation, liquidity and the potential for excess returns when needed most. This may serve in sharp contrast to portable alpha strategies that often source alpha from riskier investment strategies that may exhibit a materially high correlation with equities during periods of equity market stress.

Importantly, unlike equities and other investments, from an investor’s standpoint, bonds have the structural benefit of eventually returning the capital invested (at par value) unless the issuer defaults. Therefore, yield tends to be a reasonable indicator of return over longer periods of time for high-quality fixed-income investments and portfolios. While the shape of the yield curve and yield spreads relative to money market instruments may vary over time, the end result is higher potential returns relative to money market rates across most market environments. In today’s market environment, of course, the levels of yield provided by even the highest-quality, non-Treasury fixed-income securities are compelling.

Portable Alpha Is Alive And Well

2008 represented a noteworthy test of portable alpha strategies, particularly for those employing lower-quality, less liquid and/or leveraged investment strategies in the alpha portfolio. The year also highlighted the importance of counterparty, investment and operational risk management of portable alpha programs.

Looking forward, what seems almost certain is that investors will demand transparency both in terms of the risk exposures in the alpha strategy and the collective portable alpha approach—and invest only in strategies where they have a good understanding of the combined risk exposure, the associated investment rationale and also the downside risk over their investment horizon. The end result may be that investors migrate out of some types of portable alpha strategies and into others.

The fundamental value of portable alpha is still very much alive and well—and approaches that meet key criteria as highlighted in Figure 5 are likely to provide powerful results to long-term investors prospectively, from both return enhancement and diversification perspectives. In particular, given the extraordinary level of yield premiums available from very-high-quality fixed-income assets currently, investment-grade fixed- income-based collateral alpha strategies may provide long-term investors with attractive returns in the coming years.

This article contains the current opinions of the authors but not necessarily those of Pimco.

 

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